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When a former employee of Cohort — a small-cap technical and advisory services provider for defence and security firms — cashed in nearly 20,000 share options on his departure, the firm’s stock price dropped 7%. “It’s just ridiculous,” says Simon Walther, finance director of the £34m (€43m) UK company. “There is a big disproportion between the volumes being traded and the price at which the share is being traded because no one is there to buy 20,000 shares. Liquidity is a big issue for us.” That’s leading him to wonder what happens when Cohort’s share option plans mature and employees go to the market looking for cash to make a big purchase such as a car. “How do I get rid of 7,000 shares?”

Liquidity is an issue that most CFOs of small- and mid-cap companies in Europe must grapple with, not least because competition for investors’ attention is growing as more and more of these firms list on exchanges such as the London Stock Exchange’s AIM, Deutsche Börse’s Entry Standard and Euronext’s Alternext.

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One way to attract attention is through independent analyst coverage but small- and mid-caps often only have their house brokers to help them get their story out to the market. “There is a weakness in the quality and volume of research generated by stockbrokers for small issuers,” says Philip Secrett, head of capital markets at Grant Thornton, an accountancy firm and a nominated adviser for AIM. The London Stock Exchange, for its part, says it is developing a set of recommendations to boost analyst coverage of small issuers, which should be ready by the end of the year. But a spokesperson stresses, “It will be much more about brokering a solution than providing it.”

How can under-covered firms persuade independent analysts to publish research on them? CFOs and investor relations experts agree that coverage is driven not only by a good story and growth potential, but also by regular communication and intelligent targetting of the analyst community. The last two factors can eat into a CFO’s time though — Walther spends nearly a third of his time out of Cohort’s office, knocking on the doors of potential analysts and investors in London.

Is it worth the effort? Absolutely, says Secrett. Coverage drives investor interest and liquidity, which in turn leads to a more accurate share price and a truer company valuation.

And there are other unfavourable consequences of dropped coverage. In a 2007 study — Is there life after loss of analyst coverage? — three US finance academics compared a sample of 2,753 firms that had lost their coverage with a similarly sized control group that had not. Researchers found that one year after losing coverage, the sample companies’ performance in areas such as market value, liquidity and institutional shareholder interest had fallen compared with the control group. What’s more, the sample companies had a higher probability of delisting. In the first two years after losing coverage, 29% of them delisted, compared with 8% of the control firms. Between two to five years after losing coverage, the percentages increased to 34% and 18% respectively.

Simona Mola, assistant professor of finance at Arizona State University and co-author of the study, says the team came up with two hypotheses. The first — limited attention — argued that investors who can invest in only a limited number of stocks use analysts’ reports as a source of information. When an analyst drops a stock, it falls off investors’ radar screens. Here, lost coverage is a cause of delisting.

To test the hypothesis, researchers identified a sub-sample of the 163 top performers from the 2,753 firms. They matched the sub-sample against a control group and found that in the year following loss of coverage, there was no difference in performance between the sub-sample and the control group, although the sub-sample still had a higher probability of getting delisted.

That left the academics with another hypothesis — superior information. This suggests that analysts have data that allows them to predict more accurately than investors which companies have a higher probability of getting delisted, and drop coverage in anticipation.

There are two other reasons for analysts to stop following a company. The first is poor performance. Giampaolo Trasi, vice chairman of the European Federation of Financial Analysts’ Societies, says, “Systematic disappointment in meeting earnings targets often implies that the company is not paying enough attention to investors’ needs.” Three consecutive quarters of disappointing earnings can be enough to get dropped. The second reason is monetary, and more relevant to most small- and mid-cap CFOs. If the liquidity of a stock is so low that there is little chance of earning brokerage or underwriting fees from it, analysts are less likely to cover it. This is compounded by the separation of analysts and brokers in investment banks. As a separate function, analysts are a more expensive overhead, which makes them less likely to cover low-return stocks.

Two things may help companies get information about themselves out into the market despite low liquidity. The first is an increase in company-commissioned research. “Because smaller companies become frustrated at the lack of research, they have had to go out and buy [it] from independent research agencies,” says John Pierce, CEO of Quoted Companies Alliance, which represents small- and mid-cap listed firms in the UK.

“We encourage our members to do this because at least it’s additional information in the market about that company. While some criticise it as not being truly independent, if it’s produced by a house with its own reputation to guard, the information should be fairly objective.” Not only that, new regulations across the European Union require such reports be clearly labelled as sponsored.

The second trend has been triggered by the slowdown of the bull market. “The advisory community has been focused on primary issues rather than looking after existing clients,” says Grant Thornton’s Secrett. “It’s more interesting to take 3% to 6% of an IPO than drum up business for existing issuers. But that party [for brokers] has come to an end. There’s been a refocus on managing the secondary market.”

Knocking on Doors

It’s a development Walther should welcome. Since Cohort’s IPO on AIM in 2006, the only research published on the company has been from brokerage house Investec. So after joining Cohort two months after the IPO, Walther has regularly met with analysts who are interested in the firm’s story even if they won’t commit to coverage, because they can’t envisage any returns on investment. “I can accept that to a certain extent,” says Walther, who sees two solutions: growing the business to a market capitalisation that will get it noticed and finding other ways to increase liquidity. On growth, Cohort has been pursuing a “buy and grow” strategy since listing. Two acquisitions — of Mass Consultants and SEA Group, both software and engineering firms serving the defence sector — have increased turnover from £18m to £34m within one year and taken market cap to £70m. Walther reckons the next acquisition, still to be found, will push Cohort through the £100m barrier. As for liquidity, the finance chief wants to generate interest among investors who are willing to buy smaller share packages — family trust funds, private clients and retail investors. For staff who might hit a wall when they try to cash in their share options, Walther is considering setting up an employee benefit trust where Cohort could hold shares sold by employees until they can be passed on to bigger investors.

Alongside this, he is tirelessly pursuing a communications strategy with analysts. Fundamental to the strategy is targeting the right analysts and understanding what they want. “The first thing I ask any analyst is, ‘Are you interested in technology and defense stocks?’ If he says no, then there’s the door. If he says yes, then you start to talk,” says Walther. To ensure that the discussion is constructive, he has honed two areas: developing a well-structured presentation about a good company story and delivering what the analyst wants. “After that, it’s really just about knocking on doors,” says Walther. “There’s nothing else to beat it. If you don’t go out and meet these people, you’re not going to get anywhere.”

Good Housekeeping

While busy chasing analyst coverage, it’s important not to neglect the daily duties of driving operational efficiency and growing the company — one reason why analysts cover a stock in the first place. That’s something Dave Lemus knows all too well. The CFO of Morphosys, a €62m German biotechnology company, had no problems attracting analyst coverage following its IPO on the Neuer Markt — Germany’s now-defunct exchange for technology stocks — in 1999. From three analysts covering the company at the time of the IPO, it reached an all-time high of 26 in 2000, including major investment banks and many local German banks.

Lemus says the company had several things on its side. It was the height of the tech boom and companies pursuing antibody technology were in favour. As the first German biotech IPO, Morphosys attracted significant interest, being 66 times oversubscribed, and the company struck a “double-digit million dollar” deal with Bayer (now Bayer Scherring). In addition, Lemus launched an “extremely aggressive” IR programme. “I got on the road with our German IR agent and saw all the major opinion makers in Frankfurt and Hamburg,” Lemus recalls. “We were on the road for several days and on the back of that we had a number of excellent recommendations from stock newsletters that were quite influential.” Morphosys’ stock price climbed from around €25 at the end of 1999 to more than €440 during 2000.

But by 2005, analyst numbers had dropped to 12 and the share price fell to a low of €28.98. What went wrong? It wasn’t only the bursting of the dotcom bubble or the Neuer Markt closing in 2002. (Morphosys is now listed on the TecDAX 30.) Lemus reckons investor and analyst sentiment was hit by other developments. These included a patent dispute with Cambridge Antibody Technology (CAT), which was costing the company more than €6m a year; an expensive foray into developing its own drugs — rather than less risky partnerships with big pharma firms; and a proposed merger with British Biotech, which collapsed after news of the deal was leaked.

But Lemus hunkered down and sorted out the problems. In 2002, the patent dispute with CAT was settled. The company also restructured, laid off one-third of its staff and shifted its emphasis from long-term investments — such as proprietary drug development — to revenue-generating activities, including the launch of a catalogue business selling antibodies. In 2004, Morphosys became cash positive for the first time and a new research deal with Swiss pharma giant Novartis — in which Lemus negotiated $30m (€19m) of funding for R&D and technology licence fees, plus a further €9m investment in Morphosys’ bonds — gave the company some good news to take to the market.

In addition, Lemus temporarily limited IR activities to Germany. “As things got worse, the focus was very much on going back to the home market and establishing credibility there after having fallen slightly out of grace with the investor community in the early 2000s,” he explains. He also beefed up the IR team. After a series of investor road shows and meetings with analysts — and buoyed by improved company performance — Lemus sensed that the tide was starting to turn. It was only then, around 2006, that he expanded IR activities into the rest of Europe and North America.

Analysts are starting to return, albeit at a much slower pace. At last count, 14 analysts were covering Morphosys and its share price is hovering around the €36 mark. Lemus reckons it’s hard to say what came first — the loss of coverage or the fall in share price. “But if you were to ask me, ‘If we were able to keep all 26 analysts during a time that the markets were falling, would we have fared better?,’ my answer would be yes.”

Keep Delivering

Keeping analysts’ attention is a challenge Stéphane Boissel, CFO of Innate Pharma, a €14m French biotech firm, is currently facing. For a small-cap, Boissel has done well attracting analyst coverage. Along with Société Générale and Bryan, Garnier & Company — both of which worked on the company’s IPO on Euronext Paris in 2006 — Innate Pharma is followed by NexResearch and Raymond James Euro Equities. The latter started its coverage in summer 2007, following regular meetings with Boissel since the IPO. “We are probably the smallest company that Raymond James covers in terms of size,” says Boissel. “The two analysts we met really were very interested by the story. They understood it and they believe it has great potential so they decided to cover the stock, although I believe it’s not very economical for the firm at this stage.”

That’s true, says Eric Le Berrigaud, the Raymond James analyst covering Innate with his colleague, Thierry Verrecchia. Innate Pharma came to Le Berrigaud’s attention after Novo Nordisk — a big Danish pharma he also covers — took a 20% stake in the company at the IPO. (Novo Nordisk has collaborated with Innate Pharma since 2003 and entered into a €25m deal in 2006 to develop new drugs targetting natural killer cells.) “The IPO meeting was very close to the office so I decided to go just to understand what they were doing and why Novo Nordisk was interested in the company,” says Le Berrigaud. The analysts wanted to know more about the technology Innate was using and because, as a small cap, it would not take up much time, Le Berrigaud and Verrecchia decided to initiate coverage. “Unfortunately, the stock price has not gone in the right direction but well, that’s life,” says Le Berrigaud. After floating at €4.50, the share price has slid to around €1.90. Boissel thinks the stock price is due to the poor market conditions experienced since the summer but Le Berrigaud reckons there’s more to it. He says, “2007 was a year free of any announcement and it’s hard for a small-cap firm to perform without any news flow.” Some big investors have bailed out and in France, where the biotech sector is not mature, it’s hard to get smaller, risk-averse investors interested.

So what’s in it for Le Berrigaud? “It’s hard to stop coverage with no reason other than economics,” he says. “Today, would we make the same decision to cover the stock? I’m not sure.” That said, both he and Verrecchia still believe in Innate’s work and, although they are unhappy about the share price, they’re willing to continue coverage until the first clinical data is available this summer. If the data doesn’t deliver, they’ll feel happier about dropping coverage. “Until then, let’s give them a chance to prove that they’re a good company with good management,” Le Berrigaud says.

What can Boissel do to avoid being dropped by Raymond James? Probably not much more on the IR front. The key to any analyst-company relationship is trust. “This is not something you can build overnight. It’s something that you have to build over the long term by being transparent, clearly explaining how you intend to deliver, and then delivering,” says Boissel. Transparency and explanations are not a problem — Le Berrigaud says Innate is “above average” at communicating. Delivery is another matter.